Three Rules to IPO Trading Success

There are few sectors as volatile, risky, yet as potentially lucrative, than initial public offerings (IPOs).

Every time a company turns to the public markets to raise cash, it’s either a boom or bust. Very rarely are they ever just flat.

This week was no exception. The much-hailed Tesla Motors (TSLA) has been a smashing success so far. The maker of six-figure electric sports cars’ shares opened for trading around $18 and have soared in the past two days to more than $30 per share (a gain of 60%+).

Although Tesla has already started giving back some gains, the success of the Tesla IPO just shows the opportunities that exist in the IPO market. And if you play by the right sight of rules, you can do really well in any type of market and limit risk.

IPO Trading Success: Play by the Rules and Win Big

There’s always something going on in the IPO world. Either new companies are being listed, touted, and run or they limp out of the gates and just slowly and steadily dive. Either way, there’s usually and a good opportunity with them.

There are three rules anyone looking to score a few wins in IPOs must follow though:

Rule #1: Never bet against Wall Street – The financial world has come to realize that the stock market is rigged. Goldman Sachs’ alarming consistency over the last year has made that abundantly clear. Its trading operations have been profitable on more than 95% of all trading days.

That’s why when it comes to IPOs, where all of the shares are placed with the investment banks’ closest allies, you do not want to bet against them.

For example, the Tesla Motors IPO has had a heck of a run. It has largely done so because it’s in Wall Street’s best interest. A single hot IPO will open the market for more of them. And when investment bankers can score $50 million or more in fees for a single IPO, they have a vested interest in ensuring a widely watched IPO is very successful.

A recent study from the University of Florida has proven IPOs are some of the worst places to look for long-term gains. The study found that between 1970 and 2008, the returns of recent IPOs trailed their more established counterparts by an average of 3.5% per year over their first five years of trading. In a world where 8% to 11% is the average return, 3.5% is a big difference.

Also, IPOs have underperformed in all types of market conditions. The raging bull of the 80s and 90s was not too kind to newly listed companies. IPOs trailed similar sized companies’ shares by 4.1% in the 80s and by 3.1% in the 90s. The “lost decades” of the 70s and 00s were no different. Recent IPOs trailed by 7.6% per year in the 70s and 2.1% in the 00s.

Don’t get me wrong, Mr. Market will throw out the occasional winner to keep interest in them strong. That’s just how he works. And that’s why there will be the occasional Google (GOOG) which went from less than $100 per share to more than $600 per share. But for every Google though, there are dozens of complete busts.

That’s why we consider “investing” in IPOs a strategy doomed to fail. They are for trading and any position taken in them should be viewed as exactly that – a trade.

Rule #3: Stick to the Cycle – IPO stocks tend to run in very consistent patterns.

If they’re hot, they run up for a few weeks or months. The excitement feeds on itself. Every up day draws more investors in a “better get in now or you’ll never get in” self-reinforcing loop. These rarely last too long. And when they start to run out of gas, watch out, the weak hands are quick to sell out on the way down.

If they’re slow out of the gates, they tend to remain that way. The five worst-performing IPOs of 2010 are now down an average of 42.8% from their offer price.

History Repeats…Again

With the rules in mind, the blazing hot Tesla is shaping up to be an interesting opportunity. It looks strikingly similar to something we spotted about 10 months ago.

If you recall, the markets were struck by a flurry of excitement surrounding the IPO of A123 Systems (AONE), a company that makes electric car batteries.

A123 was the “perfect story” (remember, retail investors love stories more than value). Its technology was developed at MIT. It had partnered with top-name automakers. It received a big subsidy to build a new plant from the U.S. government. It was initially backed by some of the most successful venture firms in the world. And electric cars were a really exciting idea at the time.

It had it all. But irrational excitement doesn’t trump reality for long.

As of today, the company with no proven product, no major sales contract (GM actually passed on A123’s batteries for the Chevy Volt), very little production capacity, no near-term prospects for profitability, and sports a market cap of more than $1.9 billion.

We knew the story was good and we knew Wall Street really needed a hot IPO to kick start the IPO market (and the big fees that come along with it). So it was safe to buy for a short-term trade, but shares were going to hit some big headwinds as initial excitement faded.

Since then A123 has stuck to the IPO cycle perfectly. Close followers had the chance to pick up shares around $19 shortly after the IPO. The stock hit a high of more than $28 per share within a few days.

It was a great run until, well, until it stopped.

A123 shares have fallen steadily ever since. Right on schedule, they’ve shed 2/3rds of their value in the past two months.

The way things are looking, Tesla Motors is in the exact same position.

It has a great story. It was founded by some top venture capital backers. It has a product that has generated a lot of media attention. Its sales are subsidized by the U.S. government.

But in reality, it has a product that is expensive and doesn’t have mass appeal. The launch of its electric sedan, which Tesla is betting most of its future on, is two years away (and that’s assuming no major setbacks). And any earnings are even farther away than that.

So right now the best move is to wait for the first sign of weakness and get in position to take some safe, reliable gains on the downside.

Finding Profits in Any Market

It’s kind of exciting to see the IPO market roar back to life. And it’s only appropriate a high-profile, high-flying IPO is leading it.

More importantly though, this emerging situation shows there are opportunities available for those willing to look for them. And in the case of a long-run bear market we’re in, those willing to learn how to find stocks to bet against, will do very well.

But the key is to always stick to the rules like not betting against Wall Street in the short-term, identifying patterns and cycles, putting the odds in your favor, and always developing a plan and sticking to it.

The rebound in IPO that’s sure to follow soon will help prove there’s always an opportunity somewhere. You’ve just have to know where to look and how best to take advantage of them.